The Other Side of Value: The Gross Profitability Premium
Read the paperopens doi.org in a new tab
What they found
Novy-Marx showed that a simple measure of profitability, gross profits (revenue minus cost of goods sold) divided by assets, predicts stock returns about as well as book-to-market does, on U.S. stocks from 1963 to 2010. Profitable firms earned higher returns than unprofitable firms despite having higher valuations. Because profitability and value are negatively correlated, combining them produced far better results than either alone. The paper directly motivated the profitability factor in Fama and French's five-factor model.
What you can use
- Quality (profitability) is a real premium, not just a slogan; profitable firms outperformed unprofitable ones.
- Gross profit is a cleaner signal than net income because it is harder to manipulate and less noisy.
- Buy cheap stocks that are also profitable; value alone drags you into value traps, profitability alone into expensive names.
Caveats
Long-short factor portfolio, gross of costs; effect is stronger in small caps. Published 2013, so most of the sample is in-sample for the finding.
Tags: factor, profitability, quality, value
Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.